Monday, July 30, 2018

This Week's Message: We'll Hope For Scenario 3, But We'll Work With Whatever We Get

My fundamental view of the world at large (and, thus, the trend in the dollar) remains basically what it was at the beginning of the year; that the U.S. economy’s relative strength will make for a higher dollar and, thus, a plunging gold price, etc. going forward (it was very much a minority call at the beginning of the year).As it turns out, as of late, that was a decent call:

The Dollar Index:

Gold:

I also had the technicals supporting my thesis. The MACD has been an effective technical indicator for me with regard to currencies; although I’m not talking about the MACD signal line (that’s not a factor in my currency analysis), but rather its overall trend. I have found MACD divergences from the price of a given currency pair (or the dollar index itself) to be better than average indicators of a coming change in trend.

Per this chart, a very definite bullish divergence (MACD [panel 2] rising while the dollar index was falling) had formed during the second half of 2017, again, supporting my fundamental (contrarian) view; signaling that the dollar was on the verge of changing direction (which it ultimately did):

Now, however, my technical indicator is at odds with my fundamental view. I.e., a very clear bearish divergence (MACD trending lower while the dollar index was moving higher) has been developing since the end of May:

This technical signal is also finding confirmation in the Euro/USD cross. I.e., a bullish divergence is forming for the Euro (the highest-weighted cross currency in the dollar index):

Even the Yen is now beginning to look suspect:

This makes for some interesting possibilities if indeed my technical analysis is once again signaling a coming change in trend; which would be a decline in the dollar and a rally in the Euro and other currencies. Which suggests that one of the following three fundamental scenarios is likely to play out:

1. The U.S. economy’s growth rate will slow in the second half of the year, with the Eurozone, in particular, regaining its lost momentum from last year. U.S. interest rates would presumably stall near present levels (eliminating or sufficiently questioning the differential case for the dollar), as Eurozone yields rise and the prospects for ECB (European Central Bank) tightening gets put back on the table (the ECB softened its stance last week as Draghi signaled that its policy rate may go unchanged through summer 2019).

2. The U.S. economy’s growth rate will slow in the second half at a pace exceeding that of a slowing global economy. Such a scenario would likely occur amid a heightening of trade tensions and the world waking up the fact that the U.S. may be the ultimate (or biggest) loser -- amid fresh (ex-U.S.) trade deals occurring among the U.S.’s old trading partners (a substantial number of such deals are being negotiated as I type).

3. The U.S. economy continues to strengthen, with the Eurozone catching some real steam at the same time. The latter could bring back the dollar bears from the beginning of the year (bidding the Euro higher while they sell the dollar) as, in addition to the Eurozone economy attracting fresh capital, the ECB would certainly move to tightening mode (alleviating to some degree the dollar’s current interest rate advantage). An end to the “trade war” would be the event that could foster such a scenario.

Scenarios 1 and 2 (2 virtually for sure) would likely have equity markets grinding through the year in what will look like a long, volatile, consolidation pattern, waiting for the trade headwinds to abate. Should the trade issues become protracted, we’ll have to assume that general conditions will ultimately deteriorate to the point where even the end of trade tensions won’t be enough to save the economy from the next recession, or, thus, keep us from moving to a defensive posture in client portfolios.

Scenario 3 would be notably bullish for equity markets around the globe, as the lower dollar (with no trade war) would be bullish for U.S. industrials, materials and tech (although, despite the big boost to tech’s prospects, my guess is that the former two would take the lead [with financials likely leading the entire pack]) for the remainder of 2018.